mRORAC: A stable and market adapted risk-adjusted performance measure for capital allocation

Abstract

This paper proposes the modified Return on Risk-Adjusted Capital (mRORAC), a stable alternative to traditional RORAC for divisional risk-adjusted performance evaluation. mRORAC allocates capital cost savings rather than the traditional cost employed in RORAC, ensures bounded fluctuations, preserves risk-return rankings, and maintains other important properties. Unlike RORAC’s reliance on exogenous hurdle rates, mRORAC aligns divisional metrics with market-implied risk pricing by endogenizing capital costs through a Capital Asset Pricing Model (CAPM) equilibrium framework, optimizing economic value added. This dual equilibrium tool bridges internal capital allocation with external market dynamics, offering robust solutions for institutions in volatile risk environments.